Download - Five Parity Conditions in IFM

UNIVERZA V LJUBLJANI FACULTY OF ECONOMICS

CONTENTS ENDInternational Finance© Mojmir Mrak



1. The Purchasing Power Parity Theory2. The Interest Rate Parity Theory3. The Fisher Effect4. The International Fisher Effect5. Forward Rate as an Unbiased Predictor of the Future Spot

Rate6. Synthesis of the Parity Conditions Theories in

International Finance

CONTENTS AND PURPOSE

Purpose: get acquainted with the conceptual basis for the analysis of

exchange rate changes



1. The Purchasing Power Parity Theory PPP Concept

Basic logic: the exchange rate between two currencies should ensure that the

Law of One Price holds not only with respect to one good, but with respect to an identical basket of goods and services in the two countries

Assumptions of the Law of One Price: zero transport costs, no barriers full information identical quality of goods and services, universal basket of goods

and services



spot exchange rate is determined by the relative prices of similar baskets of goods

Absolute Version of PPP

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Relative Version of PPP and Mathematical Derivation

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Empirical Tests of PPP

interpretation problems: which prices should be used to calculate the price level? short run or long run?

problems of the theory: unrealistic assumptions statistical problems (identical basket of goods?) ignores capital flows cause-and-effect relationship between the exchange rate and

prices?



Empirical Tests of PPP

Empirical tests results: long run traded goods and services sector countries that are geographically close to each other high rates of inflation in comparison to their trading partners

Best usage: long-run target exchange rate to which the exchange rate between

two currencies should move



2. The Interest Rate Parity Theory (IRP) IRP Concept

Basic logic: capital flows between two countries occur as a result of differences in

their interest rates size of the difference is extremely important for the size of the difference

between spot and forward exchange rates of the two currencies forward rate discount/premium is closely related to the difference in the

national interest rates

Investor can invest at home or abroad: exchange the domestic currency for a foreign currency in the spot market,

invest the foreign currency in a foreign money market instrument, convert the resulting proceeds back to the domestic currency in the forward market



IRP and Covered Interest Arbitrage (CIA)

IRP ensures that investments of similar risk yield similar profits

if an investment in a home country and an investment abroad yield the same profit, then there is no possibility for CIA

CIA: no exchange rate risk, because sale/purchase of a foreign currency

in the spot market occurs simultaneously with the sale/purchase of the same foreign currency in the forward market



Empirical Tests of IRP

Deviations from IRP: transaction costs international capital flows barriers political risk investors wish to spread their wealth to decrease risk

Fairly convincing empirical support: especially euro-currency market transactions deviations from IRP are mainly the result of capital controls, taxes

and other capital transfer tariffs and transaction costs



3. The Fisher EffectFE Concept

Basic logic: arbitrage causes the equalization of the real rates of return, the real

interest rates

balance will be reached when the difference in nominal interest rates will be equal to the difference in expected rates of inflation



Empirical Tests of FE

countries with higher rates of inflation have higher nominal interest rates

arbitrage that occurs with enormous international capital flows forces the real interest rates in the most important countries to converge to the same level

national capital markets segmentation: main explanation for empirically low correlation between nominal interest rates and expected rates of inflation



Assumptions: perfect competition in the goods market and in the financial

market all countries consume an identical basket of goods certainty and identical risk of domestic and foreign securities perfect international capital mobility

4. The International Fisher EffectIFE Concept

Basic logic: difference in real interest rates will initiate international capital

flows



UIP: borrow domestic currency at a fixed interest rate and for a given

period of time in financial center A exchange the borrowed domestic currency into a foreign currency

in financial center B immediately, deposit at a fixed interest rate for the same period of time as the domestic currency was borrowed in financial center A

domestic currency is bought at the end of the period at the spot exchange rate that is prevailing at that time

risky transaction whose profit/loss depends on the difference in future and current spot exchange rate

The International Fisher Effect and Uncovered Interest Arbitrage (UIP)



Empirical Tests of IFE

validity depends crucially on perfect exchangeability of domestic and foreign securities: perfect international capital mobility investors’ perception that investments at home and abroad are

equally risky

empirical tests support the idea that the countries with high rates of inflation and high nominal interest rates are usually also the countries whose currencies tend to depreciate

low support to the relationship between the differences in nominal interest rates and the expected movement of the spot exchange rate



5. Forward Rate as an Unbiased Predictor of the Future Spot Rate

FUS Concept

Assumptions: all relevant information is quickly reflected in both the spot and

forward exchange markets low transaction costs perfect capital mobility and identical risk (financial instruments

are perfect substitutes)

spot and forward rate depend completely on the current expectations of economic agents



Mathematical Derivation and Explanation of FUS

if there exists a forward premium on home currency with respect to the foreign currency, then the home currency is expected to appreciate with respect to the foreign currency

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Empirical Tests of FUS

immediately after 1973: foreign exchange market quite efficient forward rate is the unbiased predictor of spot rate in the short run

newer empirical tests: impossible to test the foreign exchange market efficiency, the

foreign exchange market is not efficient forward discount currencies usually depreciate with respect to the

forward premium currencies even if we assume that the forward rate is an unbiased predictor of

the future spot rate in the long run, this is not true in every single moment



6. Synthesis of the Parity Conditions Theoriesin International Finance

strong theoretical basis for the understanding and explanation of the international financial environment, especially the factors that influence changes in exchange rates



Expected percentage change in spot exchange rate of

home currency relative to foreign currency

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Forward premium/discount on foreign currency

Difference in expected rates of inflation

Difference in interest rates

International Fisher effect

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Forward rate as an unbiased predictor of the future spot rate

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Purchasing power

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Fisher effect eDEM

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Interest rate parity

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Download - Five Parity Conditions in IFM

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